Investing in Real Estate Investment Trusts (REITs)

1. What are REITs?

- Real estate investment trusts (REITs) are investment vehicles which own and operate income-generating real estate such as retail malls, office buildings, healthcare facilities, hotels and warehouses. Investors in REITs gain exposure to these properties for a relatively small capital outlay.

- Most of a REIT’s returns come from its distribution per unit (similar to dividend per share) although capital gains are also possible.

2. Why invest in REITs?

- REITs generate revenue through the rental income paid by tenants on their property. From time to time, REITs may also generate a profit by buying property at a relatively low price and selling it later at a relatively higher price. This is called asset recycling.

- Singapore REITs do not need to pay tax if they pay out at least 90% of their profit to unitholders. This incentive means that REITs can, most of the time, be relied upon as a source of passive and regular income.

- REITs are governed by the Securities and Futures Act and are regulated by the Monetary Authority of Singapore in accordance with the Code on Collective Investment Schemes. They should be differentiated from Business Trusts which may also own income-generating assets but are governed by the Business Trusts Act.

3. What are the risks?

- The market price and distribution of a REIT reflects the market’s overall confidence in the economy, the property market, the returns of the property owned by the REIT and the REIT’s management.

- There are three main risks in investing in a REIT:

1. risks to income because of a drop in rental revenue and/or falling occupancy.

2. risks to asset values because of downturn in the property market

3. risks of leverage or interest rate risk because the REIT has taken on too much debt and/or its cost of debt has increased (perhaps because of a higher risk premium and/or rising interest rates). Under current MAS rules, borrowing by REITs cannot exceed 50% of their total assets.

Over the course of 2022, note that REITs suffered because interest rates were raised quickly all over the world by central banks who were looking to curb inflation.

- As REITs depend on the rental income from their tenants, any cash flow issues experienced by their tenants may negatively impact their revenue. For example, REITs performed badly during Covid-19 as many tenants had to suspend operations.

4. Other considerations

- In general, REITs which have anchor tenants (e.g. a supermarket, cinema) or globally recognized brands as tenants are likely to have signed long-term, multi-year rental agreements and should not be too badly exposed by a tenant’s cash flow problems.

- In the same vein, REITs which have a large diverse pool of small tenants (i.e. retail shopping centres) may face a more challenging environment.

- A REIT’s ability to meet its financial obligations can be measured using leverage ratios. One common leverage ratio is the debt-equity ratio. By comparing a REIT’s total liabilities to its shareholder equity, we can get an idea if a REIT’s debt level is too high.

- Another useful measure to look at is the REIT’s interest coverage ratio. This measures the REIT’s ability to meet its interest payments and is calculated by dividing its earnings before interest and taxes (EBIT) by its interest expenses. If the ratio is above 1, then even if the REIT is unable to repay the principal amount of its debt, it is still, theoretically, able to cover its interest expenses.

- Depending on the type of property they own, different REITs may face different sectoral risk factors. For example, a REIT which invests mainly in hotels (i.e. a hospitality REIT) is dependent on the number of visitors patronizing its hotels and this fell sharply during Covid-19.

- Also, the current trend towards working from home is affecting demand for office space and this will adversely impact office REITs.

- A low rental cash flow would in turn affect the REIT's ability to service its own financial and operational obligations, and the stress is made more acute by REITs having to pay out 90 per cent of their annual distributable income in order to qualify for tax exemption.

- In addition, the interruption of revenue may lead to financial problems such as higher borrowing costs and difficulty in obtaining both debt and equity capital, at precisely the time when it may be critically needed.

Not all REITs are the same. Besides the different sectors, the strength of the sponsor also makes a difference in the quality of a REIT. Sponsors are usually large, well-established property companies which can help support the REIT by providing a regular pipeline of properties as well as help secure favourable financing terms.

It is always advisable to check if who the sponsor is (if any), the track record of the REIT manager, diversify and not put all your eggs in one basket.

Note:

For free and unbiased financial education on personal investing, you can visit the Institute for Financial Literacy (IFL). IFL provide talks and workshops to the public and do not promote financial products. Their financial education programmes cover basic money management, financial planning and investment know-how.

Disclaimer:

The information presented here is to provide general awareness and educational purposes and does not constitute specific financial or investment advice. Any mention of private or public organisations, reference to products or numbers used, are for the purpose of providing illustrations to help in understanding concepts being presented.

You are always encouraged to consult a licensed financial advisor, relevant government agencies and/or your family before making any major financial decisions.

Credit Counselling Singapore

Published 10 March 2023.